Background

We offer a lucrative 401(k) plan to our employees. Recently one of our employees, who was actively deferring into the plan, is departing. He has both accrued PTO and vacation. We are not sure if there should be 401(k) deductions. Our plan uses W-2 compensation for purposes of all contributions.

Question

Are we supposed to deduct 401(k) contributions on final accrued PTO and vacation payout? If so, does he receive matching contributions as well?

Answer

Generally, answer is yes and yes. For a participant’s compensation to be deferred into a 401(k) plan, the amount must meet the plan’s definition of “compensation.” We highly recommend reviewing your plan document for definition of compensation. A plan that uses W-2 compensation that is paid after the termination of employment that is regular compensation for the employee’s services, commissions, bonuses, or other payments that would have been made to the employee if he had continued employment, qualifies as true compensation and deductions should be taken. Additionally, the following two criteria has to be met in order for the payout to be considered true plan compensation:

1. The compensation is paid by the later of 2-1/2 months after severance from employment or the end of the plan’s limitation year that includes the date of the severance from employment; and
2. The amounts would have been included in the plan’s definition of compensation if they had been paid before the employee separated from service

It is worth noting that compensation payout, such as severance package, conditioned upon termination from employment, is not considered plan compensation for purposes of contributions. Why not? It would not have been paid should the employee had continued employment.